(Extract from page 82 of BIS Quarterly Review, March 2016)
Several factors have been supporting the rise of electronic trading in fixed income markets, including: (i) the reduction in trading costs due to technological advances; (ii) changes in the demand for liquidity services; and (iii) regulatory reforms, which provide both direct and indirect incentives to trade electronically.
Technological advances, such as the significant rise in computing speed and capacity, have enabled ETPs to match and process increasingly large numbers of trades. This has contributed to lowering the marginal and average costs of each individual trade as well as to reducing search costs, which in turn raises the incentives for market participants to trade on ETPs. In addition, the entry barriers for new platform providers, such as the fixed cost of building new trading systems, have declined and have benefited from favourable funding conditions. As a result, the number of ETPs offering trading in fixed income instruments has further increased. Even though this may reduce market liquidity by fragmenting trading activity, increasing competition among ETPs can be expected to reduce the price charged to market participants for trading, thereby reinforcing the push towards electronification.
Changes in the demand for liquidity services represent another driver of electronic trading. For one, the expansion of primary bond issuance over the past few years and increased bond holdings by market participants that seek to adjust their portfolio allocations at short notice (eg funds that face redemptions) have raised the potential size of secondary bond markets. This suggests greater opportunity for economies of scale to be realised by ETPs, in particular for standardised products that are traded frequently. Another trend, as emphasised by many market participants, is an increasing demand for price transparency. In this regard, ETPs provide an efficient means of monitoring markets, comparing prices (eg of multiple dealers) and documenting that trades have been executed at the best available price. Furthermore, the persistent decline in the level of yields over recent years has induced many fixed income investors to monitor their cost of trading more closely, incentivising greater use of electronic trading and automated execution of their portfolio reallocations.
The broader post-crisis response has provided additional impetus to the electronification of fixed income markets. Regulatory reforms to contain systemic risks in the financial system have provided both direct and indirect incentives for electronic trading. Mandatory clearing of standardised OTC derivatives and supplementary trade reporting requirements, for example, have directly induced a shift in trading activity to ETPs. In addition, ensuring compliance with enhanced pre- and post-trade transparency requirements provides another strong incentive to move trading activity. Other regulatory changes, arguably reinforcing market-driven adjustments after the crisis, have raised banks' costs of taking risk. Moving trading activity to ETPs is one way to compensate for the reduced liquidity provision by these traditional market-makers. This is because ETPs enable banks to provide liquidity at lower cost (see above) or offer the opportunity for other market participants to provide liquidity (see the section on market implications).